Friday, September 23, 2016

Unit Economics Explained - Part 1: Why Unit Ecomics Matter

The single best tool for analyzing a potential entrepreneurial or investment opportunity is Unit Economics. Unit Economics answer three basic questions, perhaps the three most important questions to ask when analyzing a new opportunity: 
  1. Break Even – How many units must you sell in order to pay your monthly overhead? 
  2. Pre-tax Cash Flow – How much profit is this business likely to make every month? 
  3. Payout – How long will it take to recoup the up-front capital investment? 
There are plenty of other financial questions you could, and should ask, but many are more relevant to more established businesses. Other questions require different tools. 

Why These Three Questions?  

If Break Even is too high, then it’ll be hard to get the business off the ground, and the business will be at risk from
competitive pressures. Conversely, if Break Even is low, then the business won’t need much, if any capital to launch, you can start earning a profit faster, and the business will scale more easily.

Similarly, if Pre-tax Cash Flow is too low, then why bother pursuing the opportunity in the first place? If it’s too low, you also won’t have enough cash to continually invest in more growth and to build a cushion for a rainy day. Conversely, a high Pre-tax Cash Flow, and thus lots of money in your pocket, is the goal, or one of the goals, of every successful business. A strong Pre-tax Cash Flow also allows for more growth by providing breathing room to invest in marketing campaigns, hire more or better employees, save up to buy equipment, and so on. Strong Pre-tax Cash Flow also mitigates risk, such as losing a big client, losing a lawsuit, or experiencing price wars. 

If Payout is too long, you (or your investors) would be better off investing in a different, less risky, or less capital intensive opportunity. Markets change, new competitors enter the market, recessions hit…all sorts of things can happen in the months or years before you reach Payout. However, if Payout is short, or better yet, immediate, then you’ll quickly have nothing but your time at risk. Also, the faster you reach Payout, the faster you start getting a return on your investment and the better that return will likely be. This will, in turn, help you attract outside investors, if you need them at all.

But How Do I Do It?

In the next post, Part 2 of this series, we'll identify the basic unit and cost assumptions. In Part 3, we'll dive into the four simple formulas that comprise the Unit Economics calculations. In Part 4, we'll briefly discuss Advanced Unit Economics, though this topic is far too big cover completely in this series. In Part 5, you'll learn the most common mistakes in Unit Economics and how to avoid them. Finally, in Part 6, we'll summarize all you've learned.


Click here to read the next post in the series:
Unit Economics Explained - Part 2: Units and Costs

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